Single-stock ETFs take the field but many yellow flags are falling

Regulators, analysts and financial advisers worry the easy access to enhanced performance will hurt unsophisticated investors.

Welcome to the brave new world of single-stock ETFs and all the fallout that comes with it.

With the first batch of the latest ETF innovation hitting the market in July, the wealth management space, including some regulators, appears to have been caught flat-footed by the reality of funds offering such specific exposure to the great unwashed masses of investors.

While single-security funds have been available in Europe for a few years and the kind of leveraged and shorting exposure offered by the new ETFs is already prevalent in the U.S., the single-stock factor has triggered much debate about how they should be used, and by whom.

“The people who should be using these ETFs are sophisticated traders, and the vast majority of investors shouldn’t even be thinking about touching them,” said Nate Geraci, president of The ETF Store.

Right around the time the Securities and Exchange Commission was approving the first single-stock ETFs in mid-July, SEC Commissioner Caroline Crenshaw published a memo warning of the potential harm to investors who might not understand the nuances of ETFs designed for active traders.

“Because of the features of these products and their associated risks, it would likely be challenging for an investment professional to recommend such a product to a retail investor while also honoring his or her fiduciary obligations or obligations under Regulation Best Interest,” Crenshaw wrote. “However, retail investors can and do access leveraged and inverse exchange-traded products through self-directed trading. While investors can gain similar upside and downside exposures to an equity security through the use of options and other derivatives, single-stock ETFs are likely to be uniquely accessible and convenient for self-directed retail investors, in particular.”

A month later, after more than a dozen of the ETFs had been launched by a handful of providers, Massachusetts Secretary of the Commonwealth William Galvin announced plans for a “sweep of single stock ETF offerings.”

Galvin’s statement vowed to protect “Main Street investors” from potential harm by initiating a “sweep of complex single stock exchange-traded fund offerings recently made public and offered through Massachusetts registered broker-dealers.”

Much of the concern is centered on the ease with which unsophisticated investors can gain leveraged or inverse exposure to a single stock. While individual investors could go through the hoops of establishing short or leveraged positions in a brokerage account, the single-stock ETFs make it too easy for anyone to wander into unfamiliar territory.

“My biggest concern is these are offering an easy-button approach,” said Geraci. “The positive here is the convenience factor for investors who want to make tactical trades on single names, maybe around earnings announcements or other news. Now you can do that with some added juice. But by and large, these are tools for speculation.”

CATERING TO SPECULATORS

Providers of single-stock ETFs make no bones about the fact they’re catering to speculators who want to place short-term bets on popular stocks.

A glance down the list of recent offerings speaks for itself.

AXS 1.5X PYPL Bear Daily (PYPS) offers inverse exposure to PayPal Holdings Inc. (PYPL), while AXS 1.5X PYPL Bull Daily (PYPT) offers leveraged exposure to PayPal.
GraniteShares 1x Short TSLA Daily (TSLI) offers short exposure to Tesla Inc. (TSLA), while GraniteShares 1.25x Long TSLA Daily (TSL) offers leveraged long exposure to the electric vehicle manufacturer.
Daily AAPL Bear 1X Shares (AAPD) offers short exposure to Apple Inc. (AAPL) stock, while Daily AAPL Bull 1.5X Shares (AAPU) offers leveraged exposure to the stock.

“I don’t think financial advisers are going to be jumping into this, and I think financial advisers should not be jumping into this, because if they run a practice with long-term time horizon in mind, these products will hurt portfolios,” said Todd Rosenbluth, head of research at VettaFi.

“These ETFs are best used as short-term trading vehicles the day before Apple’s earnings, or on the possibility that Tesla will report lower monthly orders,” he added. “Like every other leveraged or inverse ETF, the longer it’s held the greater the risk. They can serve a purpose, but it’s a very specific purpose.”

COMPOUNDING EFFECT

Beyond just exposing investors to the enhanced upside or down movement of the underlying stock in the ETF, there is the compounding effect as the funds rebalance daily.

The financial instruments used to create the leveraged or inverse performance of the underlying stock are settled daily, which means the compounding can work for you if things are going in the right direction. But if the price goes against the direction of the ETF for multiple days, the downside is amplified.

As Crenshaw laid out in her memo: “The daily rebalancing and effects of compounding may cause returns to diverge quite substantially from the performance of the, in this case, one underlying stock, especially if these products are held over multiple days or more. In other words, investors’ returns over a longer period of time might be significantly lower than they would expect based on the performance of the underlying stock.”

To be clear, there is no evidence that the providers of single-stock ETFs are promoting them as anything but tools for sophisticated traders. But that doesn’t diminish the concern about how easy it is for anyone with a Robinhood account to start making leveraged and inverse bets on specific stocks.

“The key for us is education, which is why we have an educational center link within our website,” said Ed Egilinsky, managing director at Direxion, which launched its first four single-stock ETFs in early August.

“Do your homework before considering an investment in this, because they’re not appropriate for everyone,” he added. “We’ve been in the levered and inverse ETF space since 2008, and we’re always going to look for where we can provide exposure and make sure the underlying has enough liquidity and depth to be traded on a daily basis.”

Greg Bassuk, CEO at AXS Investments, said the levered and inverse strategies employed by single-stock ETFs has been used by sector and industry ETFs in the U.S. for at least a decade. AXS was the first company to launch a single-stock ETF when it rolled out eight funds on July 14.

“I go back to the notion that there’s nothing new about what we’re doing,” he said. “The way these products work is exactly the way they’ve worked for over a decade for traders with a high-conviction view. They’re time-tested.”

Will Rhind, founder and chief executive of GraniteShares, also feels confident single-stock ETFs will find their place among the appropriate base of traders.

“We started this whole thing by launching these in Europe almost three years ago,” he said. “In the last couple of years, the regulatory rules around listing and launching ETFs had been harmonized and updated. The ETF Rule allowed any issuer to launch a levered ETF and that’s what opened the door. Single-stock ETFs are just an evolution of the industry.”

GAMIFICATION WORRIES

The evolution is what scares advisers like Jason Siperstein, president of Eliot Rose Wealth Management.

“Single-stock ETFs are inappropriate and way too risky for over 99% of investors,” he said. Siperstein added that the easy access to amplified performance “is something most educated investors would not pursue.”

“In my opinion, these are tools that gamify investing, which I think can be very dangerous,” he added. “It makes me think of Robinhood, but on steroids.”

Nevertheless, the cat is out of the bag and it’s game on, as Geraci sees it. “I think the floodgates are going to open on these products and I think we’ll see all kinds of variations,” he said. “The ones that will be most successful will be offering exposure to the higher-profile names. You could also see covered call strategies on single names. Right now, there are about 3,000 ETFs, but we could have 4,000 or 5,000 by year-end just because of all the variations.”